Welcome to the Third World, Part 7: Bye Bye, Public Services

Meredith Whitney was an obscure Oppenheimer & Co. bank analyst back in
2008 when she broke from the pack and predicted Armageddon. She was right,
the pack was wrong, and she parlayed her new-found fame into a research boutique
of her own.

Last year she went for it again, predicting that the next big crisis would
be in municipal bonds, as U.S. cities, counties and states ran out of money
and started defaulting. This call didn't pan out as quickly:

Meredith
Whitney Loses Credibility as Muni Defaults Fall 60%
July 15, 2011 -- Time is running out on the credibility of Meredith Whitney,
who has yet to acknowledge that her eight-month-old prediction of widespread
defaults this year in the market for state and local government debt is
proving unfounded.

Defaults fell 60 percent in the first half of 2011 compared with the same
period last year, including a $12.5 million Austin, Texas, apartment project
that made a late payment in June, according to Distressed Debt Securities
Newsletter.

Meredith Whitney, 41, who started New York-based Meredith Whitney Advisory
Group LLC in 2009 after leaving Oppenheimer & Co., predicted 50 to
100 "sizable" municipal defaults as states slashed spending, in the interview
with CBS Corp.'s "60 Minutes."

Whitney, the analyst who rose to prominence by predicting Citigroup Inc.'s
2008 dividend cut, predicted "hundreds of billions of dollars" of municipal
defaults within 12 months in a Dec. 19 "60 Minutes" broadcast, fueling
a wave of selling in the $2.9 trillion market. Instead, the number has
fallen as cities slashed spending to balance budgets and state lawmakers
stepped in to guard against insolvency and local bankruptcies.

"The data is not helping Meredith," said Matt Fabian, a managing director
at Municipal Market Advisors, a financial- research company based in Concord,
Massachusetts. "It's always been a possibility there would be a wave of
defaults. You can't say that it's zero but it's given no sign of starting."

But fast forward a year and Whitney's looking pretty smart. A wave of California
cities have gone bankrupt, with more around the country in the pipeline. Consider
this from yesterday's Wall Street Journal:

Hard
Times Spread for Cities
Fiscal woes that have caused high-profile bankruptcies in California are
surfacing across the country as municipalities struggle with uneven growth
and escalating health and pension costs following the worst recession since
the 1930s.

Budget crunches already have prompted Michigan lawmakers to authorize emergency
fiscal managers, and led the mayor of Scranton, Pa., to temporarily cut
the pay of all city workers to the minimum wage.

In a majority of the nation's 19,000 municipalities--urban and rural, big
and small--stagnant property tax revenues, less aid from states and rising
costs are forcing less dramatic but still difficult steps.

Moody's Investors Service recently said that while municipal bankruptcies
are likely to remain rare, it warned of a "a small but growing trend in
fiscally troubled cities unwilling to pay their debt obligations."

"We need help right now," said William Schirf, the mayor of Altoona, Pa.
Crime in the city of 46,000 rose 11% last year, while the number of police
officers fell 8% over three years because of budget constraints. The city
has reduced the number of streets it is repaving and clearing of snow,
and cut down on leaf pickups and removing dead animals, trash and bicycles
from roadways.

Altoona officials projected a $3 million deficit for fiscal 2012. Under
state law, the city can't raise property taxes--its greatest source of
revenue--any higher. In April, Altoona was declared fiscally distressed
under a state law, enabling it to restructure its finances. "We just don't
have the income to match our expenses," said Mr. Schirf.

A study by the Center for Retirement Research at Boston College found that
annual pension payments for state and local plans more than doubled to
15.7% of payrolls in 2011 from 6.4% a decade earlier.

The Nelson A. Rockefeller Institute of Government said local governments
made roughly $50 billion in pension contributions in 2010, but their unfunded
pension liabilities still total $3 trillion and unfunded health benefit
liabilities are more than $1 trillion.

Local government cuts are one factor slowing the broader economic recovery,
offsetting stronger private-sector growth. State and local government spending
and investment fell at a rate of 2.1% in the second quarter, according
to the Commerce Department, the 11th consecutive quarterly drop. Local
governments also have cut 66,000 jobs in the past year, mostly teachers
and other school employees.

"Cities are still going to be facing very rough waters for the next couple
of years," said Michael Pagano, dean of the college of Urban Planning and
Public Affairs at the University of Illinois at Chicago.

Princeville, N.C., a small town in the eastern part of the state, handed
control of its books to a state commission in late July after struggling
to pay for water system updates. The town temporarily turned off water
services to about 200 homes, but many residents said they couldn't afford
the higher bills.

There also was a backlash in Michigan after Gov. Rick Snyder won legislative
approval of a measure that allowed him to appoint emergency managers for
troubled cities and school systems--allowing collective-bargaining agreements
to be tossed. Voters will decide in November whether to repeal the law.

To boost revenues, cities are increasing fees and property taxes--where
they can. In Chicago, private investors are investing in public infrastructure
projects. El Monte and Richmond, Calif., want to tax soda.

Indeed, while housing is showing signs of improvement, real estate assessed
values remain depressed, eroding property tax receipts, which provide 29%
of revenue for municipalities, according to a Moody's analysis of census
data. State aid, the biggest source of revenue for local governments at
34%, is falling and the growth of receipts from wage, sales and other taxes,
which provide 10% of local budgets, is slowing.

At the same time, pension and health-care costs are rising despite efforts
to restructure those benefits. The most vulnerable cities are ones that
experienced drastic reductions in property values or are in states like
California that limit municipal options to increase revenues. In addition,
nearly a third of California cities require collective bargaining and prohibit
outsourcing of administrative and maintenance services.

Since 2008, four California municipalities have filed for bankruptcy protection--Vallejo,
Stockton, Mammoth Lakes, and most recently, San Bernardino, which declared
bankruptcy Aug. 1, in large part because sales and property taxes fell
after the real estate bust. The assessed value of homes in San Bernardino
dropped to $10.3 billion in 2011 from $12.2 billion in 2008.

On top of a declining property tax base, the city has faced a significant
drop in sales tax collections since 2005. Economist John Husing said San
Bernardino's retail sales fell 30% during that period. Likewise, a decline
in construction means less revenue from things like building permits and
development fees.

While many municipalities nationwide have offset property-tax declines
by raising tax rates, California's 1978 law dubbed Proposition 13 caps
property taxes at about 1% of a home's value and forbids major tax increases
unless a home is sold or rebuilt, though it permits taxes to fall if a
home's value drops.

Residents in El Monte, Calif., 15 miles east of Los Angeles, will vote
in November on a soda tax that could raise about $10 million annually.
The city, which lost four major car dealerships that generated a large
share of the city's sales tax revenue, cut nearly 30% of its workforce
to help close a $3 million budget deficit but still faces $2 million deficit
for the current year.

Local merchants oppose the measure. "I'm struggling to stay open and here
they want to tax me even more. It's crazy," said Arthur Meier Jr., who
owns Arts World Famous Burgers in El Monte.

Elsewhere, the cost of shoring up underfunded pension plans for public
workers is going slowly. In many states, benefits are guaranteed and difficult
to modify unless a city is declared "fiscally distressed." "Because of
the guaranteed nature of benefits, there's no quick fix," said Thomas Fitzpatrick,
an economist with the Federal Reserve Bank in Cleveland.

Steven Kreisberg, collective bargaining director at the American Federation
of State, County and Municipal Employees, the nation's biggest public-sector
union, said pension problems were caused by investment losses that can
be gradually recovered, rather than due to overly rich benefits. "When
you lose 20% of your assets in a single year that's what created the problem," he
said.

Providence, R.I.'s $423 million pension system staved off bankruptcy after
reaching a tentative deal in May to cut pensions for retirees and current
police, firefighters, and municipal laborers, resulting in a savings of
about $18.5 million a year. Its pension plan was expected to consume about
20% of city tax collections in fiscal year 2012.

Pensions were "unaffordable and unsustainable," said Mayor Angel Taveras,
a Democrat, who lowered his own salary 10%, cut 200 city employees, closed
five schools, and secured $40 million in voluntary payments from tax-exempt
universities and hospitals, including Brown University.

In Chicago, Mayor Rahm Emanuel, facing a projected $369 million budget
gap, created an infrastructure trust backed by financial companies including
J.P. Morgan Asset Management and Citibank. The investors will put up $1.7
billion for projects approved by a five-member board, the first being considered
is a $200 million energy retrofit of city buildings expected to save $20
million a year in heating bills.

Boston is increasing property assessments of tax-exempt organizations like
universities, while Maryland passed a law allowing cities to assess a storm
water fee to help pay for projects to clean up the Chesapeake Bay.

Other cities like Cleveland and St. Louis are imposing new fees for city
services, such as trash collection. Such fees "can better link the funding
of services to people that actually experience the benefit" said Michael
Nadol, managing director with Public Financial Management, who advises
municipalities on fiscal issues.

Some Thoughts

This is another example of easy money distorting price signals and leading
people to behave in ways that, in retrospect, look extremely stupid. It worked
like this: Washington ran consistent, large deficits and/or kept interest
rates artificially low, which raised the nominal returns on stocks, bonds,
and real estate and led city officials and union leaders to think that they
could get away with sweetheart contracts featuring insanely generous pensions
and health benefits.

Then, when things got a bit tight, these same municipal and union officials
the rolled dice and refrained from fully funding these plans in order to avoid
telling hard truths to taxpayers. A few years of this and the imbalances have
become so insurmountable that the only solutions are 1) absolutely devastating
cuts in services that are the reason city governments exist, 2) defaults on
the bonds that cities used to finance their overspending, and 3) eventual
bankruptcy in which public sector unions are stripped of the pensions that
they assumed were written in stone.

Muni bond investors, meanwhile, will discover that the "risk free" parts of
their portfolios are anything but, leading to harder times for retirees and
some wild capital migrations out of munis and into...who knows?

The cumulative result is lower living standards for almost everyone. Private
sector workers who are spared the immediate public sector wage/benefit cuts
will still have crumbling schools, cops and firefighters stretched too thin
to respond on time, bad roads, libraries with empty shelves and erratic hours,
etc., etc. All the pathologies, in other worlds, of a country that hasn't
yet developed into a nice place to live.

Except that we're regressing to this stage, which will be much harder psychologically.
As the old saying goes, it's easier to be poor if you've never been rich.

At the risk of belaboring the point, the real culprits aren't living in these
cities. They're in Washington, still at work distorting the monetary system
for their own gain, trying their best to fool the rest of us into even more
malinvestment.

John Rubino edits DollarCollapse.com and has authored or co-authored five
books, including The Money Bubble: What To Do Before It Pops, Clean
Money: Picking Winners in the Green Tech Boom, The Collapse of the Dollar
and How to Profit From It, and How to Profit from the Coming Real Estate
Bust. After earning a Finance MBA from New York University, he spent the
1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst.
During the 1990s he was a featured columnist with TheStreet.com and a frequent
contributor to Individual Investor, Online Investor, and Consumers Digest,
among many other publications. He now writes for CFA Magazine.